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Wednesday
Jul302014

Staff Guidance, Accredited Investors, and "Reasonable Steps": Rewriting the Safe Harbor for Income Verification

Rule 506(c) allows issuers to market private placements through general solicitations. They must, however, take "reasonable steps" to make certain that they sell only to accredited investors. The rule provides some non-exclusive safe harbors with respect to the "reasonable steps" that will ensure conformity with the rule.

With respect to income, the safe harbor essentially requires verification based upon an IRS form. As the rule states: 

  • In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

The safe harbor, therefore, suggests that a variety of documents can be submitted to meet the requirement. Moreover, while the safe harbor speaks about the "income" for the year, presumably any combination of these documents would be sufficient to show that the investor had annual income in excess of the thresholds in Regulation D.     

The staff received a question, however, as to the verification of income for a year when the relevant "form" was not yet completed.  As the question stated: 

  • Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?  

The existing safe harbor seemed to implicitly address that question. The safe harbor was not limited to tax returns. Income could also be verified through the submission of a variety of forms, whether W-2s or 1099s or other IRS forms. These forms might not show the "income for the . . . most recent year[]" but would establish that the investor exceeded the relevant threshold.  

Yet the staff took the opportunity to effectively expand the reach of the safe harbor. The staff conceded that the safe harbor was not available in these circumstances ("No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances."). Nonetheless, it then proceeded to rewrite the safe harbor and make it available.    

  • We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:  
  1. reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
  2. obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. 

This is a substantial change in, and weakening of, the safe harbor.  

First, the requirement at least implicitly ties verification to the need for a tax return. It is enough to show that "an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available." Since individuals often have multiple sources of income (W-2, 1099, K-1, etc), no single IRS "form" will report "income for the "recently completed year" except a tax return. Thus, even if other IRS forms are available, as long as the tax return is unfiled, self-certifified, and without accompanying documentation it is permitted.  

Second, the advice does not address the possibilty that the filing date of the tax return can be manipulated. Extensions (the first of which is more or less automatic) can result in tax returns not being filed for a year or longer. 

Third, the staff replaced the need for a document filed under penalties of perjury (an IRS document) with self certification, which has no such requirement. The staff took this position despite the fact that the Commission emphasized in the adopting release the importance of requiring documentation that was subject to "penalties for falsely reporting information." See Exchange Act Release No. 69959 (July 10, 2013) ("With respect to the verification method for the income test, there are numerous penalties for falsely reporting information in an Internal Revenue Service form, and these forms are filed with the Internal Revenue Service for purposes independent of investing in a Rule 506(c) offering.").  

Fourth, while the interpretation requires the examination of IRS documents for two earlier years, it does not impose any explicit obligations that must arise from that analysis. Where, for example, the earlier year shows an income amount that does not qualify, the guidance does not specify that this requires greater diligence. Indeed, the guidance provides that in some cases further investigation (additional verification) will be required but does not reference data from the earliest of the returns. 

  • Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary. 

The guidance alters the income safe harbor in a manner arguably inconsistent with the representations made in the adopting release in Rule 506(c). The safe harbors were designed to eschew self-certification. They were designed to implement the "reasonable steps" requirement primarily through third party documentation of income and net assets. The guidance in this case, however, has undone much of that approach, permitting self certification in place of third party verification.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here

Tuesday
Jul292014

Staff Guidance, Accredited Investors, and Civil Unions

CorpFin put out some staff interpretations of the standards for accredited investors. They are dated July 3, 2014 and can be found here.  

The definition of accredited investor in Rule 501 of Regulation D (17 C.F.R. 230.501) provides a net asset test. The test looks to the assets of the investor singularly or together with a spouse. See Rule 501 ("Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000"). Use of the term "spouse" is limiting and predates the advent of civil unions.  

One query addressed by the staff was whether assets jointly owned "with another person who is not the purchaser's spouse" can be "included in determining whether the purchaser satisfies the net worth test in Rule 501(a)(5)?" The staff had this to say: 

  • Yes, assets in an account or property held jointly with a person who is not the purchaser's spouse may be included in the calculation for the net worth test, but only to the extent of his or her percentage ownership of the account or property. 

In other words, the full value of the asset cannot be included; only the actual value attributed to the investor. The answer also suggests that the SEC will accept a valuation based upon percentage ownership (say 50-50), the formula that would presumably be used in connection with ownership in common. Joint ownership provides that the survivor takes the entire property (the definition is here). The SEC's approach, therefore, does not take into account the value associated with survivorship. Nonetheless, it is easy and straightforward.  

The more significant concern is the exclusion of values related to non-spouses. The term "spouse" is not defined (certainly not in Regulation D and apparently not in the securities laws). While there is presumably no issue that "spouse" includes persons involved in same sex marriages, the issue of "civil unions" is far from clear.  

Civil unions and civil partnerships have become a permanent part of our legal landscape and social order. State statutes permitting the relationships have indicated that civil unions/partnerships are designed to have the same rights and benefits as marriage. The staff has not, however, explicitly taken the position that these relationships are included in the term "spouse."  

In other circumstances, the Commission has included the concept of "spousal equivalent." The term “spousal equivalent” was first employed in 2000 when the Commission amended the standards for auditor independence. The term was defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” The Commission has not, however, addressed whether the term includes civil unions or civil partnerships.  

The issue is in play with respect to the crowdfunding proposal. My comment letter discussing this issue at length (in the context of the crowdfunding proposal) can be found here. The easiest solution would be for the staff to issue guidance clarifying that spouse includes partners in a civil union/partnership. To the extent that does not occur, the ongoing analysis of the accredited investor definition should include a recommendation that the rule be amended to explicitly include these relationships in the income/net asset tests.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here

Monday
Jul282014

Market Structure Reform and the SEC (Part 2)

Professor Coffee, in his piece in the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term, raises structural concerns with the market and asserts that the SEC has been slow to implement reforms. As he colorfully notes: "[T]he SEC has studied high frequency trading at length, but seems unable to do much more than re-arrange the deck chairs on the Titanic." He then offers an explanation of sorts. The answer is not capture.   

  • Some will allege that the SEC has been “captured,” but that charge seems misplaced in this context, because the industry is itself intensely divided. The exchanges are doubtful about the “maker/taker” system that has become dominant in the wake of Regulation NMS, and the Securities Industry and Financial Markets Association (“SIFMA”), the industry trade group, wants major reforms. But the dark pools are largely owned by major banks, who have a different agenda. 

Instead, the answer is workload and a predilection for the status quo.  

  • Thus, the SEC’s inactivity seems better explained by two factors: (1) the SEC has been overextended by the demands of implementing Dodd-Frank and thus avoids issues that it can sidestep; and (2) in the field of market regulation, the SEC’s staff tends to worship at the Shrine of the Status Quo. Whatever practices have become prevalent are assumed to be efficient. But trading has evolved very rapidly since the adoption of Regulation NMS in 2007, and it is far from clear that any natural equilibrium has been reached. 

Capture, of course, need not be by the entire industry but can be by a particular segment. So a divided industry does not preclude capture.  

The explanation of worship of the status quo, however, overlooks a great deal. The Commission has indicated serious concern with market structure issues. The absence of any significant proposals to date have a number of likely explanations.   

First, the area is exceedingly complex. Identifying problems and solutions is not always easy.  Second, the Commission is divided politically; this probably makes consensus on reforms difficult. Third, there is almost certainly real concern that "reforms" may generate negative consequences that exceed any benefits. After all, a number of areas of concern are explained or at least influenced by the existing regulatory construct. Maker-taker payments, for example, operate within the caps on access fees in Regulation NMS. Significant changes will almost certainly have unintended consequences.   

Fourth, the very division within the securities industry makes reform difficult. The Commission is at its best when implementing regulatory reform that reflects industry consensus. A consensus can ensure that no single sector bears the brunt of systemic reform. That is not the case here. Many of the proposed reforms would disproportionately affect particular segments of the securities industry.

Fifth, some of the complaints about high frequency trading have a luddite feel. At least some of the advantages of HFT arise out of advances in technology. Any regulatory intervention needs to prevent harmful practices without unnecessarily restricting technological advances.    

Finally, the Commission knows that anything it does will potentially be subject to litigation (although hopefully the change in the make-up of the D.C. Circuit should reduce concerns with this possibility) and hearings on the Hill. 

This is not to say that Eric Schneiderman and private law suits don't have a role in prodding the SEC. They do. Schneiderman has been at the forefront of raising the advance peak problem whereby high frequency traders receive information before the rest of the market (his pressure on wire services to end advance disclosure is an example). The Lanier case illustrates some of the problems associated with the distribution of proprietary data by exchanges before it appears in the CTS.

So the cases are less about changing the worshiping practices of the SEC and more about pointing the Agency in the right direction.    

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here

Friday
Jul252014

Records Requests and the Caremark Standard At Issue in Delaware

Flying somewhat below the radar, the on-going case of Indiana Electrical Workers Pension Trust Fund IBEW v. Wal-Mart Stores Inc. may prove to be one worthy of closer consideration. The case stems from the alleged involvement of Wal-Mart in a Mexico bribery scheme which was the subject of an extensive expose in a New York Times article.   

As distilled by  Ben W. Heineman, Jr. a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government, the essential allegations in the Times story are as follows:

  • For a substantial period before 2005, the CEO of Wal-Mart in Mexico and his chief lieutenants, including the Mexican general counsel and chief auditor, knowingly orchestrated bribes of Mexican officials to obtain building permits, zoning variances and environmental clearances, and also falsified records to hide these payments. When the lawyer in Mexico directly responsible for bribery payments had a change of heart and reported the scheme to Wal-Mart lawyers in the United States, those lawyers hired an independent firm which, after an initial look, recommended a major inquiry.

This was rejected by senior Wal-Mart management, which instead told an internal Wal-Mart investigative unit to look into it. That unit, too, said, in early 2006, that a substantial inquiry was warranted. But top Wal-Mart leaders in the U.S., including the company’s general counsel, referred the matter back to the Wal-Mart general counsel in Mexico – the very lawyer who was allegedly at the center of the bribery scheme. Unsurprisingly, the Mexican general counsel promptly closed the matter, finding no problems and suggesting no disciplinary measures for senior Wal-Mart leaders in Mexico. He remained in his position until relieved of his duties just before the Times story appeared.

After publication of the article, the Indiana Electrical Workers Pension Trust Fund IBEW, who had received copies of the same files leaked by a whistleblower to The New York Times filed suit in August of 2012 seeking information to enable it to proceed with a derivative action against Walmart alleging that Walmart’s board had failed in its oversight responsibilities and engaged in a cover-up of the alleged scheme.  The gist of the case involved a claim brought under Delaware General Corporation Law §220.   In the initial action, then-Chancellor Strine, now chief justice of the Supreme Court, ordered Wal-Mart to hand over certain internal files (but not all the fund sought) concerning what its directors knew about certain bribery claims, including allegations that certain executives paid bribes to facilitate Mexican real estate deals, in violation of the Foreign Corrupt Practices Act.  (Ind. Elec. Workers Pension Trust Fund IBEW v. Wal-Mart Stores, Inc., Del. Ch, No. 7779-CS, 5/20/2013).

Walmart appealed and the Indiana Electrical Workers Pension Trust fund cross-appealed the decision.  Oral arguments on the appeal were heard on July 10th before the Delaware Supreme Court.  The Court will decide, among other issues, if Wal-Mart should release the files of the senior executives who briefed the directors, the Board’s Audit committee, and Maritza Munich, Walmart’s in-house counsel who resigned after the investigation was closed. 

While this may not seem worth of note—Section 220 cases are common and their impact is typically limited to the parties involved in the action there has been much speculation in certain circles that the Delaware Supreme Court could use it as an opportunity to revisit and clarify the Caremark standard.

Under Caremark, “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”  The case did not articulate any specific requirements as to the nature and quality of the oversight process.  It simply required that one be in place.

According to some commentators, including Michael Volkov, CEO of The Volkov Law Group LLC and a regular speaker on compliance, internal investigations and enforcement matters,  “[t]he Wal-Mart case presents a set of circumstances where the court could find that Wal-Mart failed to meet the threshold standard or, more importantly, failed to exercise proper oversight and monitoring of the compliance program in accordance with a more stringent standard reflecting an up-to-date recognition of the change in corporate governance requirements and expectations since the Caremark decision.

At oral argument, the Justices seemed unsure how far to extend the reach of a Section 220 books and records request and it is unclear whether the case will work any changes in the Caremark standards or not.

Justice Randy J. Holland asked Mr. Grant, counsel for the Indiana Electrical Workers about the about the purpose of its § 220 complaint.  “You are trying to ascertain if there are red flags that they board should have known” or did know about “but did nothing about?” Holland said.

Grant agreed, adding that communications and documents relating to internal auditors, audit committee member, internal investigators and former Wal-Mart compliance officer Maritza Munich are also needed to make that determination.

Justice Carolyn Berger emphasized that IBEW should be only entitled to documents that meet the “necessary and essential” standard. Berger expressed concern that what the IBEW wanted goes too far for the § 220 stage. “The description of what you would get sounds a lot like what you would get in normal discovery,” she said.

Stuart H. Deming, founder of Deming PLLC, suggests that the case could have sweeping ramifications for corporate compliance programs.

“A decision enforcing the rights of shareholders in this context should certainly heighten the sensitivity of boards of directors to their obligations under Caremark,” Deming, who represents foreign and domestic companies in a range of compliance matters.

Even if the case does not fundamentally change the Caremark analysis, some believe it will have important implications for boards of directors. 

According to Mr. Deming, “even if an opinion is issued that does not enforce the rights of shareholders in the context of the circumstance associated with Wal-Mart, the mere fact that the issue has been raised is likely, at least in the short run, to have an impact in heightening the sensitivity of boards of directors to compliance obligations.” 

It is beyond doubt that the Caremark decision could use amplification.  As corporate compliance becomes the focus of increased attention, guidance as to what constitutes adequate oversight could help both boards and shareholders.

Monday
Jul072014

The Significance of Halliburton

The Supreme Court in Halliburton, by a 6-3 majority, reaffirmed the presumption of fraud on the market. Halliburton, like Matrixx, was more significant for what it didn't do rather than what it did. The case held out the possibility that the reliance requirement would be radically changed. The Court could conceivably have adopted an actual reliance requirement that would have largely put an end to class actions in the area of securities fraud.  

The decision was disappointing to some. The folks at Wachtell noted that "[t]he case had the potential to revolutionize securities litigation, but, as decided, it will work no such change." The case did, however, impose additional burdens on plaintiffs by allowing defendants, at the class certification stage, to challenge reliance, primarily by showing the absence of "price impact." As Professor Coffee suggested, rather than plaintiffs entirely dodging a bullet, "The bullet hit, but inflicted a non-fatal wound."  

In truth, the case is not likely to have a significant impact on class actions alleging violations of the antifraud provisions. Costs will go up. Defendants will hire economists to conduct event studies in an effort to show that the alleged misrepresentations had no price impact. Plaintiffs will have to present evidence to the contrary. But these cases are already expensive and the firms on the plaintiffs side that bring them must have deep pockets. The pockets will now need to be just a little bit deeper.

On the other hand, the decision may have unintended consequences. To the extent that a class action suit survives this type of challenge, the settlement amount will likely go up. By quantifying the extent of the market impact, plaintiffs will have better evidence of alleged damages and will be in a position to insist on larger settlement amounts.   

What this case demonstrates, however, is that the limits on class actions are unrelated to the merits. The standard for scienter (the strong inference standard) doesn't really separate the wheat from the chaffe as much as it separates those where the evidence of scienter is publicly available and those where it is not. Likewise, there is no reason to believe that Halliburton will actually result in the dismissal of meritless cases. Instead, cases will be dismissed based upon the imprecise ability to show the market impact of a false statement.

Tuesday
May062014

United States v. Matthew Martoma: Denial of Martoma’s Motion to Dismiss

In United States v. Martoma, 2013 WL 6632676 (S.D.N.Y. Dec. 17, 2013), defendant, Matthew Martoma (“Martoma”), was indicted in Count One for conspiracy to commit securities fraud and in Counts Two and Three for securities fraud. The United States District Court for the Southern District of New York denied Martoma’s motion to dismiss under Morrison v. National Australia Bank, holding that Rule 10b-5 applied to the transactions because they occurred in the United States. 

According to the allegations, Martoma employed an expert-networking firm to facilitate paid consultations with medical experts in the pharmaceutical industry. The firm expressly warned clients that the consultation dialogue should be limited to information already in the public domain. Between 2006 and 2008, Martoma allegedly used the network to form relationships with two doctors (“Doctor One” and “Doctor Two”) involved with clinical trials for a new Alzheimer’s drug being conducted on behalf of two pharmaceutical giants, Élan Corporation and Wyeth Pharmaceuticals, Inc.

During this period, Martoma allegedly organized and attended approximately 42 consultations with Doctor One, who served on the trial’s Safety Monitoring Committee (“SMC”). The indictment alleged that Doctor One gave Martoma confidential information relating to the safety of the new drug. Further, the indictment contended that Martoma obtained confidential information from Doctor Two as well. After receiving the confidential information, Martoma allegedly purchased both Élan and Wyeth stock and instructed his hedge fund employer to do the same.

In July 2009, Doctor One purportedly provided Martoma with additional information indicating that the Alzheimer’s drug was ineffective. Prior to informing the public of the drug’s inefficacy, the government asserted that Martoma caused his employer to sell “virtually all of its approximately $700 million worth” of holdings in Élan and Wyeth. The hedge fund also initiated various short sales and options strategies to profit from any decline in the company’s stock. These actions, according to the government, caused the fund to realize profits and avoid losses equal to $276 million. 

Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” In Morrison v. National Australia Bank LTD., 561 U.S. 247 (2010), the Supreme Court concluded that Rule 10b-5 did not have extraterritorial effect.  For the provision to apply, the transaction at issue had to involve (1) the purchase or sale of a security listed on a US stock exchange, or (2) the purchase or sale of any other security that took place in the United States.

Martoma moved to dismiss Count Two and related parts of Count One, arguing that Section 10(b) did not apply because the subject transactions involved American Depository Receipts (“ADRs”) in Elan Corporation. The court found that the transaction met both tests under Morrison.  Although noting that ADRs could be characterized as “predominantly foreign securities transactions,” the Elan ADRs were listed on “an official American securities exchange.” 

In addition, the transactions occurred in the U.S. and not, as Martoma asserted, in Ireland.  Martoma focused on the fact that the actual shares were on deposit with the Bank of Ireland. The ADRs, in contrast, were “merely ‘receipts that may be redeemed for the foreign stock at any time,’” and, as a result, the “[t]he operative transaction for the issuance of Elan's ADRs— i.e., the deposit of Elan ordinary shares with The Bank of Ireland—was carried out in Ireland.”   

The court, however, disagreed.  Whatever the characterization of the ADRs, the focus of the analysis under Morrison was “where the transactions in the ADRs took place.”  Because the ADRs were listed on the NYSE, the relevant trade contracts, the passing of title, and the liability incurred by both parties to the transaction took place within the United States.

For the foregoing reasons, the court upheld the applicability of Rule 10b-5 to the present facts and denied Martoma’s motion to dismiss.  

The primary materials for this case may be found on the DU Corporate Governance website. 

Wednesday
Nov142012

The Supreme Court and Enforcement of The Race to the Bottom: Gatz v. Auriga Capital (Part 1)

There has been a fair amount of attention given to the opinion by the Delaware Supreme Court in Gatz v. Auriga Capital, CA 4390, Del. S. Ct., Nov. 7, 2012.  The opinion contained some sharp language criticizing the use of dicta in the Chancery Court opinion.  Gordon Smith discussed the case at The Conglomerate; likewise Steve Bainbridge did so in his blog.  Steve called the Supreme Court opinion a "smackdown" and noted that it entailed the "airing of dirty laundry that doesn't make the Supreme Court look good." 

The Supreme Court took issue with the trial court's decision to use dicta to opine on legal issues not before the court.  As the Supreme Court stated:   

the court’s excursus on this issue strayed beyond the proper purview and function of a judicial opinion. “Delaware law requires that a justiciable controversy exist before a court can adjudicate properly a dispute brought before it.”  We remind Delaware judges that the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate their individual world views on issues not presented. A judge’s duty is to resolve the issues that the parties present in a clear and concise manner. 

The admonition was not designed to prevent judges from speaking out about legal issues that might come before them.  Judges could do so but only if in speeches, law review articles, or other non-judicial forums.  Again, in the words of the Supreme Court: 

To the extent Delaware judges wish to stray beyond those issues and, without making any definitive pronouncements, ruminate on what the proper direction of Delaware law should be, there are appropriate platforms, such as law review articles, the classroom, continuing legal education presentations, and keynote speeches.

The odd thing about the criticism is that the practice of using dicta to speak on issues not before the court has been encouraged by the Chief Justice.  Indeed, he co-authored an article that amounted to an apology for the practice, something labeled the "Guidance Function."  As the article stated:

the Delaware judges have frequently crafted dicta to give valuable guidance to deal lawyers on unanswered questions. The Delaware courts recognize the need to wait for a live controversy to resolve an issue definitively, but fortunately they also recognize that this does not mean that they cannot, or should not, use the attention paid to a published opinion to offer guidance on uncertain but vital areas of corporate law.

The Gatz opinion even cited the article despite the criticims of the practice. 

Challenging the use of dicta while authorizing similar views in speeches and articles is not an easy distinction to make.  First, all judges occasionally use dicta.  Somehow a blanket prohibition on the practice seems impractical. 

Second, Delaware courts regularly cite articles written by their bretheren as authority.  See Keyser v. Curtis, 2012 Del. Ch. LEXIS 175 n. 129 (Del. Ch. July 31, 2012) ("A similar application of the entire fairness doctrine has been advocated by a member of this Court, although not in a judicial opinion. See Leo E. Strine, Jr., et al, Loyalty's Core Demand: The Defining Role of Good Faith in Corporation Law").  Thus, articles and dicta can have essentially the same legal effect.

The Supreme Court opinion, therefore, is far more confusing than clarifying in its instructions to lower courts. 

Tuesday
Nov132012

Padfield on The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Updated Draft)

I've posted an updated draft of my article, The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases, 15 U. Pa. J. Const. L. __ (forthcoming), on SSRN (here).  The abstract reads as follows:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court held that corporate political speech could not be regulated on the basis of corporate status alone. In support of that conclusion, the majority characterized corporations as mere “associations of citizens.” The dissent, meanwhile, viewed corporations as state-created entities that “differ from natural persons in fundamental ways” and “have been effectively delegated responsibility for ensuring society’s economic welfare." I have argued previously that these two competing conceptions of the corporation implicate corporate theory, with the majority adopting an aggregate/contractarian view, and the dissent an artificial entity/concession view. Even if one understands Citizens United to be primarily about listeners’ rights, this stark contrast of competing theories of the corporation is difficult to ignore. At the very least, what the majority and dissent thought about corporate speakers was relevant to the question whether the campaign finance restrictions challenged in Citizens United should fall within that narrow class of speech restrictions justified on the basis of the speaker’s identity due to “an interest in allowing governmental entities to perform their functions.” Somewhat surprisingly, however, the majority was silent, and the dissent expressly disavowed, any role for corporate theory. I have previously offered some explanations for this apparent inconsistency, and concluded that an active “silent corporate theory debate” was indeed integral to the outcome of Citizens United - despite protestations to the contrary. In this project, I examine the key Supreme Court cases leading up to Citizens United to see whether a similar silent corporate theory debate is evident in those cases. I find that there is indeed such an on-going debate, and proceed to argue that in future cases involving the rights of corporations the justices should make their views regarding the proper theory of the corporation express. This will allow for a more meaningful discussion of the merits of those decisions, and impose an additional layer of intellectual accountability on the jurists.

Tuesday
Nov132012

The Election and Corporate Governance: Political Contributions and the Role of the SEC

In the aftermath of the election, attention is likely to return to the need to impose greater transparency on corporate campaign contributions.  While Citizens United ruled out most types of substantive regulation, the case specifically approved an approach  premised around greater disclosure. 

The DISCLOSURE (‘‘Disclosure of Information on Spending on Campaigns Leads to Open and Secure Elections Act of 2012’’) Act, HR 4010, seeks to do this.  The premise of the legislation is that corporations (and other organizations such as unions) must file a report with the Federal Election Commission that discloses campaign contributions. Presumably, in the aftermath of the election, this provision will again return to the forefront. 

The SEC presumably has the regulatory authority to require disclosure of this information.  Moreover, there is a strong regulatory reason for the SEC to do so.  The DISCLOSURE 2012 ACT leaves execution of these requirements to the FEC, not the SEC.  In other words, congressional intervention would largely give control over the disclosure process to another agency.  This is not an appropriate outcome and perhaps explains stories floating around that the SEC is prepared to act in this area.   

Tuesday
Nov132012

The Election and Corporate Governance: The Pressure on Dodd Frank Eased

After the election, the press noted statements by one prominent Republican that Obamacare is the law of the land.  So, in the aftermath of the election, is Dodd Frank. 

A victory for Governor Romney would likely have put pressure on Congress to repeal significant portions of Dodd Frank.  As the WSJ reports, this hope has largely evaporated.  The article noted the possibility of "small changes . . . in the next couple of years."  In other words, Dodd Frank is going nowhere and at most there may be some modest fixes, something always possible with such a long and complex piece of legislation. 

The election cycle also provided some evidence that opposition to Dodd Frank was costly at the ballot box.  One of the people defeated in this cycle was Nan Hayworth from New York.  Hayworth sponsored a number of efforts to repeal portions of Dodd Frank, including the disclosure of pay ratios.  Arguments were made that Scott Brown in Massachusetts acted to undercut provisions in Dodd Frank

With Dodd Frank no longer in doubt, certain provisions in the governance area will need to be implemented.  One is Section 952(b) and the requirement that companies disclose compensation ratios.  In addition, the Commission ought to reconsider shareholder access, the provision struck down by the DC Circuit.  With Congress having affirmed the SEC's authority to adopt a shareholder access rule, the post election cycle may be the right time to consider another effort at implementing the requirement. 

Monday
Nov122012

The Election and Corporate Governance: The Impact on the Courts

One place where there may be a change in the legal regime associated with corporate governance is the role played by the federal courts.  As this Blog has often discussed, the federal courts have not been particularly friendly toward corporate governance related issues. 

The Supreme Court has embarked on a deliberate policy to restrict the use of Rule 10b-5 in the context of private actions.  Janus is an example; so is Morrison.

The DC Circuit has been striking down SEC and other administrative rules while evidencing little concern with the requirement of agency deference.  Shareholder access is the obvious example.  Moreover, the trend has the potential to continue with industry challenges to the Conflict Minerals and Resource Extraction Rules.  The use of cost-benefit analysis as a basis for striking down rules such as the access rule has effectively forced agencies to direct resources away from rule writing and enforcement to economic analysis.  There is no evidence that this is the best use of agency resources and in any event it is not for a court to determine.

How important is the DC Circuit?  According to an editorial in the WSJ, the DC Circuit:

provides the only check on the burgeoning regulatory state. Congress tends increasingly to write ambiguous laws, precisely to give regulators the discretion to impose far-reaching costs on the economy without the legislators having to take responsibility for the vote.

There are currently no vacancies on the Supreme Court but some could come open in the next four years.  There are three vacancies on the DC circuit, with eight active judges.  The Obama Administration has nominated two judges to fill some of the vacancies.

Four more years of the Obama Administration means four more years of judicial appointments.  No one can predict with certainty what judges appointed for life will do.  But new appointees will change the mix of views and opinions and, in the area of corporate governance, may result in more investor friendly decisions. 

Friday
Nov092012

The Election and Corporate Governance: A Lesson in Demographics

If there has been a single common subject in the analysis of the 2012 presidential election, it has been the role of demographics.  Apparently something like 45% of President Obama's votes came from people of color.  He rolled up huge margins with Latinos, African Americans and, less discussed, Asians (Asians favored the President 73% to 26%). 

Then there were women, with the President chalking up a double digit lead (12%) with that group as well.  As one study noted:  "Since 1964 women have comprised a majority of the eligible electorate, but it was not until 1980 that the percentage of eligible women who actually voted surpassed the percentage of qualified men casting ballots . . . "

These demographics caused Politico to ask whether the Republican Party was Too old, too white, too male and whether this amounted to a "glaring structural weaknesses in the GOP".  See also Vote Data Show Changing Nation.

In the area of corporate governance, the exact same question can be asked about corporate boards and about the judiciary in Delaware.  Corporate boards of public companies consist of about 15% women (one study of the 1500 largest public companies put it at 12.7%) and 10% people of color.  For the most part, this means one woman and one person of color on a corporate board.

Similarly, Delaware determines the corporate law for an entire nation.  Yet, as we have noted, it is a remarkably undiverse group of judges.  There is, among the 10 jurists on the Chancery Court and the State Supreme Court, a single woman.  They often have similar backgrounds and attend similar law schools.  Moreover, as we have also noted, this lack of diversity can increasingly be contrasted with a more diverse federal judiciary. 

Corporate boards and the Delaware courts should consider whether they also have a "glaring structural weakness" that should be seriously considered.  For the Delaware courts, the lack of diversity provides another argument for preempting state statutes and transferring matters to the federal government. 

For public companies, the lack of diversity raises concerns over the quality of the board.  Companies that figure out the importance of diversity before the others may well obtain a competitive advantage in the market place.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity

Thursday
Nov082012

The Election and Corporate Governance: The Role of Citizens United

The reelection of Barak Obama has a number of explanations that are best left to the pundits and sages to point out.  Corporate governance, however, played a small but potentially important role.

How was that the case?  The answer is Citizens United.  Put aside the unleashing of contributions as a result of the decision.  Right or wrong, the decision was perceived as permitting corporations to have a more accentuated influence during the election cycle.  The Supreme Court indicated that corporate contributions were a matter between companies and shareholders and expressly approved of disclosure regimes designed to inform shareholders and the public of these contributions.  Despite efforts in Congress, however, no such disclosure regime was put in place.

Thus, the election cycle occurred with few meaningful limits on corporate contributions.  As a result, the issue of corporate contributions became part of the debate.  With Governor Romney having strong roots in the corporate world, the debate likely increased voter focus on this fact.  Moreover, the debate engendered by Citizens United was likely responsible for the much repeated statement by Governor Romney that "corporations are people, my friend."  The phrase made its way into campaign commercials, was the subject of a spoof in an ad sponsored by the Colbert Super Pac, and came up constantly in the campaign. 

Exit polls showed that a majority of voters perceived Governor Romney as supporting policies that favored the wealthy.  Whatever the merits of the perception, candidates for national office probably prefer to be perceived as supporting policies that favor the middle class.  The Citizens United debate and statements like "corporations are people, my friend" probably in the end made the middle class orientation a more difficult perception for Governor Romney to achieve.   

Wednesday
Nov072012

Non-Reviewability of Directors' Fees: In re Huron Consulting Group, Inc. Shareholder Deriv. Litig., 971 NE 2d 1067 (Ill App. 2012)

In re Huron Consulting Group, Inc. Shareholder Deriv. Litig., 971 NE 2d 1067 (Ill App. 2012) involved a derivative suit filed in Indiana.  In considering the standard for demand futility, the courts applied Delaware law since the corporation had been formed under the laws of that state.  As part of the analysis, the court had to determine whether a majority of the board was disinterested and independent.  

Shareholders sought to show a lack of independence by pointing to the fees paid to directors.  As the plaintiff alleged:  "the members of the board of directors earned an average of $330,438 in annual salary."  Shareholders asserted that the fees were "materially higher" than those paid to directors of other corporations.  The court, however, found that the allegation, standing alone, did not establish a lack of disinterest or independence. 

His allegations that individual directors lacked independence is merely a comparison of the fees Huron paid its directors and fees awarded to directors of other Fortune 500 companies he selected. He then concludes that "[b]ecause of the sheer size of the atypical director fees" awarded to each director in this case, "there is reason to doubt [their] independence from other directors, rendering [them] incapable of impartially considering a demand to commence and vigorously prosecute this action." Plaintiff cannot survive dismissal based on such conclusory statements. . . .

Significant fees, standing alone, will not result in the loss of director independence.  The court did not provide any insight into the method of showing that fees were excessive and impaired independence.  The court, however, added an additional element to the analysis.  "More importantly, plaintiff failed to allege that any director has used his influence to pressure the others to do his bidding to further his personal interests, as the test for 'independence' requires under Rales." 

The element suggests that a loss of independence requires some affirmative evidence of actual pressure by the interested director.  Putting aside the merits of the requirement, this is an almost impossible burden to meet at the pleading stage.  Thus, non-independent boards would be treated as independent not because they were but because of the insurmountable pleading burden.   

Saturday
Nov032012

Davidoff & Hill on the Limits of Disclosure

Steven Davidoff and Claire Hill have posted “The Limits of Disclosure” on SSRN (here).  The abstract concludes that “underlying the rationale for disclosure are common sense views about how people make decisions — views that turn out to be importantly incomplete.... Disclosure’s limits reveal yet again the need for a nuanced view of human nature that can better inform policy decisions.”

Davidoff has also posted an accompanying piece on DealBook: “Reading the Fine Print in Abacus and Other Soured Deals.”  After describing a fascinating series of examples that seriously call into question the ability of disclosure to carry the weight our regulatory regime places upon it, Davidoff concludes:

This is a problem. Sophisticated investors are supposed to read the documents. We all know that retail investors don’t often take the time to read disclosure, but the securities laws are based on the idea that information is filtered into the markets through disclosure to sophisticated investors who then set the real price of the security.

This is a form of the efficient market hypothesis. If sophisticated investors can’t be bothered to read the documents and act on them, then we have a real gap in the entire disclosure regime and asset pricing generally.

Unfortunately, this is what the evidence from the C.D.O. market before the financial crisis shows. And because of this, the idea that requiring still more, better or clearer disclosure is likely to be unfruitful in many cases.

So perhaps it won’t be such a bad thing after all if the Supreme Court eventually guts our securities law disclosure regime in the name of the First Amendment.

Friday
Nov022012

South v. Baker and the Race to the Courthouse in Caremark Actions (Part 2)

So what are the implications of this approach?

The decision is thoughtful in limiting the analysis to Caremark actions.  Those claims are tough to bring under the best of circumstances.  The court clearly believes that if the race to the courthouse can be slowed, shareholders (and their counsel) will proceed in a more deliberate fashion and, at least sometimes, will opt not to file Caremark claims. 

That is not, however, the likely outcome.  Shareholders still have an incentive to file quickly.  They will argue that they have alleged sufficient facts to withstand a motion to dismiss.  Assuming they are correct, they benefited from the fast filing.  Assuming they are wrong, they suffer nothing more than the usual consequence of a dismissal (although their dismissal will be with prejudice).  

To the extent representation is deemed inadequate, shareholders who do not file quickly but instead conduct a meaningful investigation (presumably by invoking their inspection rights).  They can then  file a claim in the same action.  Thus, derivative actions involving Caremark allegations are likely to produce a class of plaintiffs who file quickly and a class of plaintiffs who invoke their inspection rights.  The former will presumably succeed sometimes, albeit in rare circumstances, and when they do not, the latter will be in a position to file a follow up action.

It is possible that the second group of plaintiffs will decide not to file once they have completed the inspection process.  They may not uncover sufficient additional facts to allow them to adequate differentiate their complaint from the one filed by the first group of shareholders.  This seems to be what the Vice Chancellor hopes will happen.  Yet this "discretion" is for the most part unlikely.  Given the existing predilection to file even without significant investigation, it presumably will not be difficult for subsequent plaintiffs to find enough additional evidence to justify a second complaint. 

The effort by the Vice Chancellor is a worthy one.  He was careful to limit the approach to Caremark actions.  Moveover, he did not require shareholders to invoke inspection rights.  Instead, he more broadly required a "meaningful investigation," something that will often but not always mean the use of inspection rights.  

The real consequence of the risk of plaintiffs who file without adequate homework is a dismissal that ultimately bars other shareholders who do engage in the requisite investigation.  The Vice Chancellor has left open the door for those shareholders.  Morover, as the practice develops, the more sophisticated firms may opt increasingly to represent shareholders who prefer to conduct a more thorough investigation before filing an action. 

Friday
Nov022012

South v. Baker and the Race to the Courthouse in Caremark Actions (Part 1)

South v. Baker, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) represents another step in VC Laster's efforts to slow the race to the courthouse at least in cases involving Caremark allegations.  It is in many ways a refinement of the analysis in Pyott

In this case, he created a presumption that counsel filing derivative claims containing Caremark allegations would be subjected to a presumption of inadequate counsel unless the suit was preceded by an effort to obtain documents under Section 220.  The analysis was an attempt not only to slow the race to the courthouse but also to reduce the number of lawsuits filed.  There may be some impact on the latter but not on the former. 

The case arose following statements by Hecla Mining Company that lowered projections for silver production and a statement by the United States Mine Safety and Health Administration ("MSHA") that disclosed safety violations by Hecla.  The statement was quickly followed by two securities cases alleging violations of Rule 10b-5 and seven derivative suits.  Some were filed in Delaware and some in Idaho, both in state and federal court.  Two stockholders who did not file suit sought documents under Section 220.  With respect to the case in Delaware, plaintiffs alleged a Caremark claim. 

Defendants sought dismissal and the court found that the complaint lacked "particularized facts supporting a reasonable inference that a majority of the Board faces a substantial risk of liability".  As a result, plaintiffs had not sufficiently alleged demand futility.  The court then addressed the consequences of the dismissal. 

The Vice Chancellor had a point to make.  In his court, those who did not precede a Caremark claim with the exercise of inspection rights risked punishment, at least where the failure was unexplained . "Wholly missing was any explanation as to why the Souths did not use Section 220 before filing suit, as the Delaware Supreme Court has recommended repeatedly."  As a result, "dismissal of the complaint with prejudice as to the Souths is a fitting consequence that does not seem likely to work any prejudice on the corporation."

A dismissal with prejudice, however, did little to slow the race to the courthouse.  Plaintiffs still had an incentive to file quickly, even if they risked dismissal.  The Vice Chancellor, however, addressed this incentive.  He noted that dismissal with prejudice of someone who filed quickly essentially penalized the shareholders that took steps to invoke their inspection rights. 

As noted, good faith disagreements exist over the extent to which a dismissal with prejudice as to the named plaintiff could have preclusive effect on the efforts of other stockholders to bring suit, including those stockholders who have attempted to use Section 220. After considering the Souths' pleading, it concerned me that if a different stockholder carefully investigated the events at the Lucky Friday mine, uncovered a meritorious claim, and wished to pursue it, the potential combination of a broad preclusion rule together with all-too-predicable results of the Souths' litigation strategy could bar the diligent stockholder from suing.

He ultimately decided that the dismissal with prejudice applied only to the existing plaintiffs, not to other possible plaintiffs.  To reach that result, he concluded that "another stockholder still can sue if the first plaintiff provided inadequate representation."  He then made a "finding of inadequacy" and, as a result, determined that the dismissal of the complaint "should not have preclusive effect on the litigation efforts of more diligent stockholders".  

The finding of inadequacy was grounded on the failure of plaintiffs to first seek to inspect documents under Section 220.  The failure, according to the court, created a presumption that the shareholder had acted in a disloyal fashion. See Id. ("When a stockholder rushes to file a Caremark claim without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests of the plaintiffs' firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.").

The presumption was limited to Caremark claims.  Id.  ("This requirement differentiates a Caremark claim from other types of derivative actions in which a plaintiff challenges a specific and identifiable board decision. In such a case, a plaintiff may well be able to plead particularized allegations without using Section 220 that are sufficient to survive a Rule 23.1 motion to dismiss"). 

The court left open the possibility that the presumption could be rebutted.  The shareholder could either produce "evidence that calls into question the requisite facts giving rise to the presumption" or could rebut the presumption by "producing evidence directly contrary to the presumptive inference."  The former could be accomplished by alleging facts "showing that the plaintiff did not file hastily and conducted a meaningful and thorough investigation."  The latter could be accomplished by adducing facts demonstrating that a quick filing "benefited the corporation and not just the plaintiffs' law firm."  Plaintiffs, however, were unable to rebut the presumption. 

We will discuss the implications of this decision in the next post.

Thursday
Nov012012

The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 7)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

We would be remiss if we did not consider the Caremark analysis employed by the court in Pyott.  In what has to be more unusual than a finding that the board violated the Blasius standard, the court concluded that the shareholders in Pyott sufficiently alleged a Caremark violation.  Such a claim could arise where the alleged conduct involved conscious behavior to cause a violation of the law.  As the court explained:

by consciously causing the corporation to violate the law, a director would be disloyal to the corporation and could be forced to answer for the harm he has caused. Although directors have wide authority to take lawful action on behalf of the corporation, they have no authority knowingly to cause the corporation to become a rogue, exposing the corporation to penalties from criminal and civil regulators. Delaware corporate law has long been clear on this rather obvious notion; namely, that it is utterly inconsistent with one's duty of fidelity to the corporation to consciously cause the corporation to act unlawfully. The knowing use of illegal means to pursue profit for the corporation is director misconduct.

The plaintiffs in Pyott sufficiently alleged this type of behavior.  The plaintiffs alleged that the board approved business plans "premised on illegal activity."  According to the court:  "The Board kept Allergan's business plan in place even after the . . . FDA inquiries illustrated the extent of Allergan's regulatory exposure."  These and other allegations were sufficient to "reasonably infer that the Board knowingly approved and monitored a business plan that contemplated illegality." As the court concluded:  "At the pleadings stage, I believe the plaintiffs are entitled to the reasonable inference that the Board oversaw company-wide efforts to promote off-label use of Botox for treating migraine headaches, which was not an FDA-approved use at the time."

The facts, therefore, look to be unusual.  It will be a decidedly rare case where plaintiffs can present sufficient allegations that a board knowingly approved a business plan that "contemplated illegality."   Nonetheless, the court took the same allegations examined by the California court and reached a different outcome.  Moreover, the court did so in a manner that benefited shareholders.  Were there to be a few more cases with similar outcomes, this Blog might have a harder time justifying the management friendly appellation usually given to the Delaware courts. 

Primary materials can be found at the DU Corporate Governance web site.

Thursday
Nov012012

The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 6) 

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

What are the implications of the decision?  First, the case could be criticized because it was not limited on its face to Caremark actions.  The decision seemed to impose a duty to inspect in all derivative actions.  A subsequent case, as we will discuss tomorrow, however, made clear that the analysis was limited to Caremark actions, circumstances where the need to inspect may be stronger than in other types of derivative suits.  Moreover, the subsequent case also clarified that the presumption against rapid filing of Caremark actions could be rebutted.  So we will put those criticisms aside. 

The clear intent of the opinion is to force counsel for shareholders to slow down the race to the courthouse, be more deliberative in formulating a case, and, ideally, actually deciding in some cases not to bring an action.  Will this occur?  Yes and no.

Clearly, counsel bringing these cases in Delaware will know that they will receive short shrift in VC Laster's courtroom if they do not first invoke inspection rights.  Whether the other jurists in Delaware will follow his approach remains to be seen. 

But invoking inspection rights will delay the filing only in Delaware.  Unless courts in other jurisdictions apply the same approach, there will be no impediment to filing a quick action in a non-Delaware jurisdiction.  To the extent that these plaintiffs survive a motion to dismiss, they will control the litigation and gain everything in discovery that the Delaware shareholders tried to obtain through an inspection demand.  As a result, this approach may in fact encourage litigation outside of Delaware.  See 2012 COLUM. BUS. L. REV. 427, 491 (2012) ("As we document elsewhere, since the mid-1990s, the rate of corporate litigation involving Delaware companies has increased, and the proportion of cases filed in Delaware courts has fallen.").

To the extent the non-Delaware court dismisses the action, Pyott makes clear that in at least one courtroom, shareholders will suffer the same fate unless they have invoked inspection rights.  At the same time, this obligation will at least in some cases result in a stronger complaint being filed in Delaware than in the non-Delaware jurisdiction.  It is possible that a few of them might survive a motion to dismiss, something that occurred in this case.     

That possibility depends upon the Delaware courts.  To the extent that Pyott effectively mandates the use of inspection rights as a precondition to a Caremark action in Delaware, it is effectively imposing on plaintiffs additional cost and additional delay.  The costs and delay will only be beneficial if in fact they sometimes result in a case surviving a motion to dismiss that otherwise would not have. 

This occurred in Pyott.  But as we noted, counsel for shareholders in the California action received all of the material obtained from the inspection request by other shareholders.  In other words, the Delaware case was allowed to go forward but there was no evidence that the complaint was any better than the one dismissed in California.  To the extent the Delaware courts continue to dismiss almost all of the Caremark claims brought by shareholders, Pyott potentially makes the process more expensive without providing any compensatory benefit to make up for these additional costs.

Primary materials can be found at the DU Corporate Governance web site.

Thursday
Nov012012

The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 5)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

Having identified the idealized version of the shareholder derivative suit (at least in a Caremark context), the court sought to turn this version into the reality. 

In reviewing the facts of the case at hand, the Chancery Court concluded that the firms filing the California actions "failed to provide adequate representation."  As a result, the dismissal in California was not determinative of the motion to dismiss the action in Delaware.

The characterization of California counsel was not, in the end, based upon the merits of the complaint but solely from the decision to file quickly.  The case, the court reasoned, "exemplif[ied] the race-to-the-courthouse problem."  Within 48 hours of the settlement between Allergan and the Department of Justice, a derivative suit was filed in Delaware.  Three additional complaints were filed within weeks of the initial suit in California. 

The complaints were "filed hastily for one reason only: to enable the specialized law firms to gain control of a case that could generate legal fees."  As a result, the company was forced to "fund the teams of the lawyers hired by the individual defendants to respond in each jurisdiction, address coordination issues, and brief parallel motions to dismiss." The court viewed the actions of the California law firms as a failure to "fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs." 

Presumably California counsel should have delayed filing and invoked inspection rights.  Had they done so, they would have had additional information to use in deciding whether to bring the action.  Yet in fact, they had that very information.  A shareholder in Delaware had successfully made a demand to inspect records at Allergan and the materials were given to the plaintiffs in the California actions.  California plaintiffs "used the materials to file an amended complaint. and used in the amended complaint."

So it wasn't about the inadequacy of the complaint.  It was about the decision of the California plaintiffs to file quickly.  As the Vice Chancellor opined:

the fast-filing plaintiffs already had shown where their true loyalties lay. Asking for and receiving the benefit of another lawyer's work did not rehabilitate them. It rather evidenced their continuing desire to control the case. In this regard, I disagree that the policy goal of encouraging plaintiffs to use Section 220 will not be undercut by a rule that affords priority to fast filers if the corporation gives them the same books and records that a diligent stockholder fought to obtain. . . . Under the rule enunciated in King I, the issue would not arise because stockholders like the California plaintiffs would not be able to file fast, suffer dismissal, and then ask for books and records to try again.

In other words, the case amounted to a warning.  Counsel bringing a Caremark action without first invoking inspection rights (and presumably undertaking some kind of deliberative process over whether to bring the case) incurred the risk that a Delaware court would view them as failing to provide adequate representation.

Primary materials can be found at the DU Corporate Governance web site.

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